Plaintiffs, Stephen A. Gregg and Kristina K. Gregg, bring this
action for refund of income taxes and penalties plus interest under the
Internal Revenue Code, 26 U.S.C. § 1 et seq. Pursuant to Fed.R.Civ.P.
56, defendant filed a motion for summary judgement seeking to dismiss
plaintiffs complaint. Plaintiffs filed a cross-motion for summary
judgment. For the reasons set forth below, the defendants motion is
denied, the plaintiffs cross-motion is allowed, and this case is
dismissed.

STATEMENT OF THE FACTS

Plaintiff Stephen A. Gregg (plaintiff) was a
member of Cadaja, L.L.C. (Cadaja) in tax year 1994. Cadaja
is a limited liability company formed pursuant to the limited liability company
statutes of the State of Oregon on November 4, 1994. The tax year for Cadaja in
1994 commenced on November 4, 1994, and ended on December 31, 1994. For tax
year 1994, Cadaja filed a U.S. Partnership Return (Form 1065) with the Internal
Revenue [*1125] Service
(IRS); and plaintiffs filed a joint federal income tax
return.

Prior to forming Cadaja, plaintiff was the CEO for Ethix
Corporation. He worked five days a week, at least eight hours per day for the
corporation, until he sold his stocks in Ethix Corporation on November 4, 1994.
Prior to the stock sale, plaintiff had held sixty percent ownership interest in
the corporation since 1990. According to plaintiff, Ethix Corporation was a
managed health care company formed to establish networks of physicians.
Insurance companies then used the networks to gain access to professionals and
obtain their services. Specifically, Ethix Corporation was a service company
that provided consulting, marketing, networking, and business services to the
health care industry. Plaintiff alleges that capital is not a material
income-producing factor in its business operations. Affidavit of Plaintiff in
Support of Plaintiffs Motion for Summary Judgement ¶ 3.

In November 1994, plaintiff created Cadaja with an intent to
transfer the business techniques he had developed in traditional medicine into
fields of alternative medicine. Plaintiff solicited the participation of other
members: Candace Cappelli and Judith Fleming. Both Cappelli and Fleming were
employees of Ethix Corporation before they joined Cadaja on November 4, 1994.
Plaintiff was the sole financier of Cadaja; the other two members contributed
no cash or property to Cadaja, however, according to plaintiff, their investment
was know-how. Both Cappelli and Fleming worked at least 40
hours per week for Cadaja in 1994 with an annual salary of $75,000. In 1994,
plaintiff worked approximately 100 hours for Cadaja, but did not receive
compensation for services he provided, because plaintiff thought it illogical
for him, as the sole financier of Cadaja, to take money out of the business on
one hand and return it to the business on the other hand.

Although Cadaja was formed in 1994, it had no offices until 1995.
Each of the individuals employed by Cadaja worked from their homes and from the
offices of Ethix Corporation until early 1995. In addition, Cadaja did not have
an Operating Agreement until May 1995, after it changed its name to
Alternarˇ Group, LLC in February 1995. The effective date
of the Operating Agreement relates back to November 4, 1994.

According to plaintiff, Cadaja was formed to create a network of
credentialed alternative medicine practitioners and develop management
capability for alternative medicine clinics. Like Ethix Corporation, Cadaja is
a service company, providing consulting, marketing, networking, and business
services in the alternative medicine and alternative health care industry.
Plaintiff alleges that capital is not a material income-producing factor in
Cadajas business operations. Affidavit of Plaintiff in Support of
Plaintiffs Motion for Summary Judgement ¶ 14.

The IRS audited the plaintiffs 1994 joint income tax
return. It disallowed plaintiffs characterization of a flow-through
loss from Cadaja in the amount of $230,723 as an ordinary loss, and
re-characterized that loss as a passive activity loss. On March 3, 1998, the
IRS issued a Notice of Deficiency to plaintiffs, setting forth a deficiency
amount of $91,366 and an accuracy-related penalty of $18,273.20 pursuant to 26
U.S.C. § 6662(a). On July 27, 1998, the IRS made assessments of the
audit deficiency, accuracy-related penalty under § 6662(a), and
interest on deficiency against plaintiffs for tax year 1994, in the amounts of
$91,366, $18,273.20, and $36,281.76, respectively.

On August 13, 1998, plaintiffs paid the deficiency assessment of
$91,366. On January [*1126] 11, 1999, in
response to plaintiffs claim for refund of $91,366, the IRS issued a
Claim Disallowance. On August 26, 1999, plaintiffs paid $26,530 toward the
accuracy-related penalty assessment. On November 10, 1999, in response to
plaintiffs claim for a refund of $26,530, the IRS issued a Claim Disallowance.

LEGAL STANDARD

Summary judgment is appropriate if the pleadings,
depositions, answers to interrogatories, and admissions on file, together with
the affidavits, if any, show that there is no genuine issue as to any material
fact and that the moving party is entitled to a judgement as a matter of
law. Fed.R.Civ.P. 56(c). The materiality of a fact is determined by
the substantive law on the issue. T.W. Elec. Serv., Inc. v. Pacific Elec.
Contractors Assoc., 809 F.2d 626, 630, (9th Cir.1987).

The moving party has the burden of establishing the absence of a
genuine issue of material fact. Celotex Corp. v. Catrett, 477 U.S. 317, 323, 106
S.Ct. 2548, 91 L.Ed.2d 265 (1986). If the moving party shows the absence of a
genuine issue of material fact, the nonmoving party must go beyond the
pleadings and identify facts that show a genuine issue for trial. Id. at 324, 106 S.Ct.
2548.

Special rules of construction apply to evaluating summary judgment
motions: (1) all reasonable doubts as to the existence of genuine issues of
material fact should be resolved against the moving party; and (2) all
interferences to be drawn from the underlying facts must be viewed in the light
most favorable to the nonmoving party. T.W. Elec. Serv., 809 F.2d at 630.

DISCUSSION

Limited liability companies (LLCs) are hybrid
entities that are, under state law, neither partnerships nor corporations. For
federal income tax purposes, an LLC can be treated as either a partnership or a
corporation. To avoid double tax for corporations, most LLCs are carefully
structured to be treated as partnerships for federal income tax purposes and
file annual information tax returns for partnerships using Form 1065. In this case,
Cadaja filed a Form 1065 for tax year 1994, and was, therefore, treated as a
partnership and subject to a single tax on its earnings, as well as deduction
on losses, at the member or partner level rather than on the entity level.

I. Passive Activity Loss

The issue in this case is whether plaintiffs ratable
share of the flow-through operating loss from Cadaja should be characterized as
ordinary loss or passive activity loss in plaintiffs joint tax return
for tax year 1994.

Ordinary losses can be applied against any income; however,
passive activity losses can be applied only against passive activity income.
Passive activity losses that are not currently deductible are carried forward
to the next taxable year. See 26 U.S.C. § 469(b). Defendant
characterized plaintiffs flow-through loss from Cadaja as a passive
activity loss, thus limiting any deductions to applicable passive gains. I
disagree.

Passive activity loss rules pursuant to 26 U.S.C. § 469
apply to individuals. See 26 U.S.C. § 469(a). Passive
activity means any trade or business in which the taxpayer does not
materially participate. 26 U.S.C. §
469(c)(emphasis added). A taxpayer shall be treated as materially
participating in an activity only if the [taxpayers involvement] in
the operation of the activity [is] regular, continuous, and
substantial. 26 U.S.C. § 469(h)(1).

The regulations promulgated for Section 469 further interpret the
material participation [*1127] standard by
instructing that a taxpayer materially participates in an activity if the
taxpayer meets one of the seven tests set forth in Temporary Treasure
Regulation § 1.469-5T:

(1) The individual participates in the
activity for more than 500 hours during such year;

(2) The individuals participation in
the activity for the taxable year constitutes substantially all of the
participation in such activity of all individuals (including individuals who
are not owners of interests in the activity) for such year;

(3) The individual participates in the
activity for more than 100 hours during the taxable year, and such
individuals participation in the activity for the taxable year is not
less than the participation in the activity of any other individual (including
individuals who are not owners of interests in the activity) for such year;

(4) The activity is a significant
participation activity for the taxable year, and the individuals
aggregate participation in all significant participation activities during such
year exceeds 500 hours;

(5) The individual materially participated in
the activity for any five taxable years during the ten taxable years that
immediately precede the taxable year;

(6) The activity is a personal service
activity, and the individual materially participated in the activity for any
three taxable years preceding the taxable year; or

(7) Based on all of the facts and
circumstances, the individual participates in the activity on a regular, continuous,
and substantial basis during such year.

Temp. Treas. Reg. § 1.469-5T(a)(1)-(7).

In addition, if a taxpayer is a limited partner of a limited
partnership, the taxpayer is presumed to not materially participate in the
activity of the partnership, except as provided in the regulations. 26 U.S.C.
§ 469(h)(2). The regulations provide an exception to the general
presumption of non-material participation as limited partners, that is, if the
taxpayer is a limited partner of a limited partnership, but meets test (1),(5)
or (6) of the seven material participation tests set forth in Temporary
Treasure Regulation § 1.469-5T(a)(1)-(7), the taxpayer is found to
materially participate in the activity of the partnership. Therefore, to
satisfy the material participation standard, a general
partner in a partnership needs to meet one of the seven tests set forth in
Temporary Treasure Regulation § 1.469- 5T(a)(1)-(7); however, a
limited partner needs to meet one of the three tests set forth in Temporary
Treasure Regulation § 1.469-5T(a)(1), (5) and (6). The standard of
material participation for a limited partner is higher than
that for a general partner.

The question becomes whether plaintiff, a member of an LLC, should
be treated as a limited partner or a general partner in a limited partnership
for Section 469 purposes. This court believes that this issue is one of first
impression.

Plaintiffs argue that plaintiff should be treated as a general
partner. Cadaja was designed to be taxable as a partnership for federal
taxation purposes for tax year 1994. Oregon state law distinguishes limited
partner status from general partner status based on a taxpayers
control, rather than liability, of an business entity. See
ORS 70.135. Under Oregon law, a general partnership interest is defined by
exclusion referring to the definition of limited partner, i.e., general partner
status is conferred upon a partner who is not subject to restrictions upon
participation in the control of the business. See ORS 70.185. According to
plaintiffs, because none of the members of Cadaja are subject to restrictions
under Oregon law or under [*1128] the
Cadajas Articles of Organization and Operating Agreement, all members
of Cadaja, including plaintiff, should be treated as general partners.

Defendant argues, however, that plaintiff should be treated as a
limited partner. Although Cadaja was an LLC formed under the Oregon Limited
Liability Company Act, for federal taxation purposes, and more relevantly, for
Section 469 purposes, Oregon law is preempted and does not apply, except as
otherwise directed by the provisions of Section 469 and its regulations. The
regulations provide that for purposes of Section 469, a partnership interest
shall be treated as a limited partnership interest if [t]he liability
of the holder of such interest for obligations of the partnership is limited,
under the law of the State in which the partnership is organized, to a
determinable fixed amount .... Temp. Treas. Reg. §
1.469-5T(e)(3)(i)(B). In other words, in the context of Section 469, without a
specific designation in the partnership agreement or certificate, the question
whether a partnership interest is limited or general turns on whether there is
limited liability under state law. If a partner has limited liability in the
partnership under state law, the partner has a limited partnership interest,
and therefore, is a limited partner in the partnership. The defendant argues
that because Cadaja, as an LLC, extended the protection of limited liability to
all of its members, including plaintiff, under Oregon law and its Operating
Agreement, plaintiffs interest in Cadaja was a limited partnership
interest and he was a limited partner for Section 469 purposes in tax year
1994.

According to defendant, for Section 469 purposes, all members of
an LLC will be treated as limited partners of the LLC that is taxable as a
partnership, because of their limited liabilities under Oregon law. Plaintiffs
argue that the limited partnership test, as set forth in Temporary Treasure
Regulation § 1.469-5T(e)(3)(i)(B) and recited by defendant, is
obsolete when applied to LLCs and their members, because the limited liability
statutes create a new type of business entity that is materially
distinguishable from a limited partnership. I agree.

A limited partnership must have at least one general partner who
is personally liable for the obligation of the limited partnership. If, for
federal tax purposes, an LLC is treated as a limited partnership, and all
members of the LLC are treated as limited partners because of their limited
liability, the consequence of such a treatment does not satisfy the requirement
of at least one general partner. In addition, LLC members
retain their limited liability regardless of their level of participation in
the management of the LLC. But a limited partner in a limited partnership
cannot, by definition, participate in the management.

Furthermore, the legislative history clearly shows that Congress
enacted the limited partnership test for the purpose of the passive activity
loss rules to thwart the deduction by investors, such as limited partners in a
limited partnership, of passive losses from tax
shelter investments against other non-passive income, since
a limited partner generally is precluded from participating in the
partnerships business if he is to retain his limited liability
status[.] Senate Finance Committee Report on P.L. 99-514 (Tax Reform
Act of 1986), reprinted in CCH Standard Federal Tax Rptr. (2000 ed.) at
¶ 21,960.

The limited partnership test is not applicable to all LLC members,
because LLCs are designed to permit active involvement by LLC members in the
management of the business. See Barbara C. Spudis, [*1128] LLCS: Recent Developments and the Developing Uses of Hybrid
LLCs, 373 PLI/Tax 1003, 1034 (1995); Hughlene A. Burton, Taxing LLC Members as
General or Limited Partners, J. Limited Liability Companies, Spring 1996, at
168, 170. Further, LLC members may materially participate in the LLC without
losing their limited liability protection. See, e.g., J. Larry Lee, The Future
of Limited Liability Companies for Business and Estate Planning Purposes in
Mississippi, 18 Miss. C.L.Rev. 91, 101 (1997); Keen L. Ellsworth, Utah Limited
Liability Companies: The Ugly Ducklings, 1992 B.Y.U. L.Rev.
1091, 1103 n. 47 (1992). In the absence of any regulation asserting that an LLC
member should be treated as a limited partner of a limited partnership,
defendants conclusion is inappropriate. Therefore, the higher
standard of material participation test for limited partners should not be
applied to plaintiff. Plaintiff materially participated in the activity of
Cadaja if and only if he satisfies one of the seven tests
set forth in Temporary Treasure Regulation § 1.469-5T(a)(1)-(7).

The first test is whether plaintiff participated in the activity
for more than 500 hours in tax year 1994. See Temp. Treas. Reg. §
1.469-5T(a)(1). Facts show that plaintiff worked approximately 100 hours for
Cadaja in tax year 1994, much less than the 500-hour requirement. However,
plaintiffs argue that this test provides an easy quantitative measure of
material participation. Five hundred hours per year equates
to 9.62 hours per week, or 10.42 hours per week assuming 48 work-weeks per
year. Plaintiff alleges that he worked at least 112 hours during the period of
approximately eight weeks, from November 4, 1994 to December 31, 1994, equaling
approximately 14 hours per week on average. On an annualized basis,
plaintiffs participation of 112 hours equates to 728 hours per year.
Therefore, according to plaintiffs, plaintiff satisfied the first test.

Defendant argues, however, that neither Section 469 nor the
regulations promulgated thereunder provide for such proration in the event of a
short year. The defendant states that the plain language if and only
if contained in § 1.469-5T(a), denotes a requirement of
strict compliance. In addition, if proration is allowed, 500 hours per year
equates to less than 10 hours per week. Such a deminimis standard of
material participation acts against the Secretary of the Treasurys
strong interest in preventing taxpayers from initiating or acquiring passive
activities at the close of a taxable year, and then characterizing those losses
as non-passive, and deducting the losses against ordinary income. Although, as
plaintiffs argue, no regulation or case law prohibits annualizing the
participation hours in the event of a short year, I defer to the
defendants explanation on how the first test should be applied.

I appreciate plaintiffs frustration regarding the
application of this test, since timing of the formation of a business entity
ironically affects the determination of the nature or level of a
taxpayers participation in the business activity under the first
test. However, plaintiff chose to form Cadaja as an LLC over other
organizational forms in November of tax year 1994 for various business reasons,
which may or may not include tax considerations. Application of this test
without strict compliance will open the floodgates defeating the regulations
purposes. Therefore, I find that plaintiff fails to meet the 500-hour-per-year
threshold requirement under the first test.

The second test is whether plaintiffs participation in
the activity for tax year 1994 constitutes substantially all of the
participation in such activity of all individuals (including non-owners) for
the same tax year. See Temp. Treas. Reg. [*1130] §
1.469-5T(a)(2). The third test is whether plaintiff participated in the
activity for more than 100 hours during tax year 1994, and the
plaintiffs participation is not less than that of any individual
(including non-owners) during the same year. See Temp. Treas. Reg. §
1.469-5T(a)(3). Plaintiff did not argue his material participation under these
two tests.

The fourth test is [t]he activity is a significant
participation activity ... for the taxable year, and the individuals
aggregate participation in all significant participation activities during such
year exceeds 500 hours. Temp. Treas. Reg. § 1.469-5T(a)(4).
Significant participation activities are defined as

(1) In general. For purposes of paragraph
(a)(4) of this section, an activity is a significant participation activity of
an individual if and only if such activity -

(i) Is a trade or business activity ... in
which the individual significantly participates for the taxable year; and

(ii) Would be an activity in which the
individual does not materially participate for the taxable year if material
participation for such year were determined without regard to paragraph (a)(4)
of this section.

(2) Significant participation. An individual
is treated as significantly participated in an activity for a taxable year if
and only if the individual participates in the activity for more than 100 hours
during such year.

Temp. Treas. Reg. § 1.469-5T(c).

Plaintiffs argue that plaintiffs participation in both
Cadaja and Ethix Corporation were significant participation activities, and his
aggregate participation in all significant participation activities
during [the tax year 1994] exceeds 500 hours. Therefore, according to
plaintiffs, plaintiff satisfies the fourth test. Plaintiffs arguments
err in mis-characterizing his participation in Ethix Corporation as a
significant participation activity under Temporary Treasure Regulation
§ 1.469-5T(c).

Plaintiff was a full-time CEO of Ethix Corporation working at
least 40 hours per week on a continuous basis until he terminated his
employment with the corporation in November 1994. His participation in Ethix
Corporation far exceeded the 500-hour minimum standard as set for in Temporary
Treasure Regulation § 1.469-5T(a)(1). Therefore, his activity in Ethix
Corporation in tax year 1994 is a material participation activity under
Temporary Treasure Regulation § 1.469-5T(a)(1). Consequently, it is
not a significant participation activity under Temporary
Treasure Regulation § 1.469- 5T(c)(1)(ii). Plaintiffs mistakenly treat
plaintiffs participation in Ethix Corporation as a significant
participation activity and combine it with his participation in Cadaja that is
arguably a significant participation activity. Therefore, plaintiff fails the
fourth test.

Since the fifth and sixth tests raise common questions, they are
discussed together. The fifth test is whether plaintiff materially
participated in the activity (determined without regard to this paragraph
(a)(5)) for any five taxable years (whether or not consecutive) during the ten
taxable years that immediately precede the taxable year [1994]. See
Temp. Treas. Reg. § 1.469-5T(a)(5). The sixth test is whether the
activity is a personal service and plaintiff materially participated in the
activity for any three taxable years (whether or not consecutive) preceding the
tax year 1994. See Temp. Treas. Reg. § 1.469-5T(a)(6). An activity is
a personal service activity if it involves the performance
of personal services in [t]he fields of health, law, engineering,
architecture ... or consulting or [a]ny other trade or
business in which capital is not a [*1131] material
income-producing factor. Temp. Treas. Reg. § 1.469-5T(d).
Both Ethix Corporation and Cadaja were business entities performing consulting,
marketing, networking, and business services for the health care industry, and
capital was not a material income-producing factor to either of them.
Therefore, plaintiffs activities in them are personal service
activities.

Defendant argues that Cadaja was formed in tax year 1994, so
plaintiffs activities in Cadaja alone do not meet the requirement of
the fifth and the sixth tests. Plaintiffs argue, however, that
plaintiffs material participation in Ethix Corporation, prior to the
formation of Cadaja, should be included in considering whether plaintiff
satisfies the fifth and the sixth tests.

Plaintiffs did not raise this grouping argument of
plaintiffs activities in both Ethix Corporation and Cadaja until
their Memorandum in Support of Plaintiffs Motion for Summary
Judgment. Defendant responds that plaintiffs grouping argument is
barred by the doctrine of variance.

Under the doctrine of variance, a taxpayer is generally barred
from asserting a claim in a refund action that was not raised in the
administrative process of a claim for refund. See 26 U.S.C. § 7422(a);
Robinson v. United States, 84 F.Supp.2d 1124, 1127-28 (D.Or.1999).
The claim must set forth in detail each ground upon which a credit or
refund is claimed and facts sufficient to apprise the Commissioner of the exact
basis thereof. Treas. Reg. § 301.6402-2(b)(1). The purpose
of this requirement is to prevent surprise and to give the IRS
adequate notice of the claim and its underlying facts so that it can make an
administrative investigation and determination regarding the claim. Boyd
v. United States, 762 F.2d 1369, 1371 (9th Cir.1985). If the [refund]
claim on its face does not call for investigation of a question, the taxpayer
may not later raise that question in a refund suit. Quarty v.
United States, 170 F.3d 961, 972 (9th Cir.1999) (quoting Boyd, 762 F.2d at
1372).

Plaintiffs argue that the issue of whether plaintiff materially
participated in the business operation and affairs of Cadaja was raised with
their administrative Claims for Refund filed with the IRS, and since their
claim never changed, there was no variance. In addition, the IRS considered all
seven tests for material participation in its
administrative decision. Therefore, plaintiffs argue that their grouping
argument under the fifth and sixth tests should be allowed.

The question here is how detailed a claim need be to provide the
IRS with sufficient notice to consider a refund claim raised by a taxpayer. A
broad claim, as occurred here, does not, on its face, call for investigation of
a question as to whether plaintiffs can group plaintiffs activities
in Cadaja and Ethix Corporation together as a single activity
in order to decide whether plaintiff materially participated in that activity.
Such a question may thus be barred. See Quarty, 170 F.3d at 972.

The grouping argument, however, is an argument only under the
material participation claim. Requiring that a taxpayer
list all possible arguments for each test under material
participation claims in his Claim of Refund is not reasonable.
Further, plaintiffs grouping argument is not frivolous and was raised
in good faith. To provide defendant with an opportunity to respond to
plaintiffs grouping argument, this court requested both parties
address the issue [w]hether Plaintiffs activities in Ethix
Corporation, a C corporation, and Cadaja, a limited liability company, can be
grouped for the purpose of Treas. Reg. § 1.469. See Civil
Minutes, doc. # 61. Therefore, under the circumstances of this case, this court
will consider the merit of plaintiffs grouping argument.

[*1132] Treasure Regulation §
1.469-4(a), in defining the term activity, allows a
taxpayer to group his or her trade or business activities, including those
conducted through C corporations that are subject to Section 469, S
corporations, and partnerships, for purposes of applying the passive activity
loss rules of Section 469. See Treas. Reg. § 1.469-4(a). This
regulation is effective for taxable years ending after May 10, 1992. Treas.
Reg. § 1.469-11(a)(1). Therefore, Treasure Regulation §
1.469-4 applies to this case for tax year 1994.

No dispute arises as to the fact that Ethix Corporation is a C
corporation that is subject to Section 469. Therefore, the issue is whether
plaintiffs activities in Ethix Corporation, a C corporation, and
Cadaja, a limited liability company, can be grouped for the purpose of
§ 469. Partners and shareholders may group activities they conducted
directly through a Section 469 entity (i.e., a partnership, an S corporation or
a C corporation that is subject to § 469) with activities they
conducted directly through other Section 469 entities. See Treas. Reg.
§ 1.469- 4(d)(5)(i). A taxpayer may group his activities conducted
through a C corporation subject to Section 469 with another activity of the
taxpayer only for purposes of determining whether the taxpayer materially
participates in the other activity. Id. § 1.469-4(d)(5)(ii).
Therefore, the grouping of plaintiffs activities in Ethix Corporation
with his activities in Cadaja is available to plaintiffs in determining whether
plaintiff materially participated in his activities with Cadaja.

Treasure Regulation § 1.469-4(c) provides general rules
for grouping activities: the activities to be grouped must form an
appropriate economic unit that is determined by looking to
all facts and circumstances with the greatest
weight placed upon (i) [s]imilarities and differences in
types of trades or businesses; (ii)[t]he extent of common control; (iii)[t]he extent
of common ownership; (iv)[g]eographic location; and (v)[i]nterdependencies
between or among the activities. Treas. Reg. §
1.469-4(c)(2). Furthermore, the fact that two undertakings are
conducted by different entities does not establish that they are different
activities. Staff of the Joint Comm. on Taxation, 100th Cong.,
General Explanation of the Tax Reform Act of 1986, 87 CIS J 86215, at 247.

The business activities of Ethix Corporation have significant
similarities with those of Cadaja. Both are personal service activities,
providing counseling, marketing, networking, and business services to the
health care industry. The only difference between the business activities is
that Ethix Corporation was involved in traditional medicine, while Cadaja was
involved primarily in alternative medicine, such as
chiropractors, naturopaths, and acupuncturists. Plaintiff had common control of
both Ethix Corporation and Cadaja: plaintiff was a CEO of Ethix Corporation prior
to November 1994, and a founding member and managing member of Cadaja since
November 1994. Plaintiff held a majority portion of ownership interest in both
Ethix Corporation and Cadaja. Finally, both business entities had their
principal places of business in Portland, Oregon.

Defendant, however, argues that the activities of Ethix
Corporation and Cadaja existed entirely independently of each other, because
Ethix Corporation was sold before Cadaja commenced operating on November 4,
1994. Defendant fails to recognize one dependency between Ethix Corporation and
Cadaja and that is that plaintiff formed Cadaja primarily because he intended
his expertise and reputation in the medical community established through his
activities with Ethix Corporation be transferred to Cadaja. See Affidavit of
Plaintiff in Support of Plaintiffs [*1133] Motion for Summary Judgment ¶¶ 7 and 15.
Such a dependency is particularly important for success of a professional
service.

Defendant further argues that both examples under Treasure
Regulation § 1.469-4(c)(3) involve a taxpayer engaging in two or more
trade or business activities at the same time. See Treas. Reg. §
1.469-4(c)(3), Example 1 and Example 2. Since plaintiffs activities
in Ethix Corporation and Cadaja did not occur simultaneously, the defendant
alleges that plaintiff cannot group his activities. Defendant errs, because no
rules or regulations require that activities to be grouped occur at the same
time. Regulation § 1.469-4, applying to taxable years after 1992,
offers a broader facts-and-circumstances test for
reasonable grouping to define the term activity than
previous Temporary Regulation § 1.469-4T that applies to taxable years
before 1992. See Treas. Reg. § 1.469-11; compare Treas. Reg.
§ 1.469-4 with Temp. Treas. Reg. § 1.469-4T. However,
Temporary Regulation § 1.469-4T provides some useful insights in
dealing with activities in professional services, such as services
performed in the fields of health ... or consulting. See Temp. Treas.
Reg. § 1.469-4T(h)(1)(ii). Example 3 under Temporary Treasure
Regulation § 1.469-4T(h) clearly stated that [t]his
[grouping] rule is not limited to cases in which the taxpayer holds such
interests simultaneously. Id. § 1.469-4T(h), Example 3.
Example 3 describes a scenario of medical services in which a taxpayer owned a
partnership in Partnership A in 1989 and became a partner in Partnership B in
1990. The grouping of the taxpayers activities in Partnership A and
those in Partnership B is permitted. See id. Therefore, plaintiff can group his
activities in Ethix Corporation and Cadaja as a single activity for determining
whether he materially participated in the activities in Cadaja in tax year
1994.

Defendant argues that even if plaintiffs activities can
be grouped for determining his material participation, plaintiff cannot
materially participate in the activity of Ethix Corporation in tax year 1991 or
earlier years to satisfy the fifth and sixth tests. According to temporary
regulations in effect for 1991 and earlier years (i.e., the Tax Reform Act of
1989), a taxpayer could not be considered to be materially participating in an
activity through a non-pass-through C corporation. See Temp. Treas. Reg.
§ 1.469-4T (1989); Connor v. Commissioner, 218 F.3d 733, 737
(7th Cir.2000) (Prior to 1992, the temporary regulations promulgated
by the Secretary to apply the passive activity rules (temporary
regulations) provided that shareholders in non-pass-through entities,
such as the corporation, did not participate materially in the activities of
such entity, and the final regulations effective from 1992 applied a
broader facts-and-circumstances test to all entities to
determine whether the activities of an entity and an individual of the entity
should be considered as a single activity, rather than explicitly excluding the
shareholders in non-pass-through entities).

Defendants argument has merit. However, if plaintiff can
group his activities in Ethix Corporation and Cadaja as a single activity under
Treasure Regulation § 1.469-4 (Definition of
activity), plaintiff can satisfy the first test, i.e., plaintiff
participated in a single activity (grouping his activities
in Ethix Corporation and Cadaja) for more than 500 hours during tax year 1994.
Plaintiffs need only satisfy one of the seven tests to meet the
material participation requirement. Therefore, I do not
need to decide whether plaintiff materially participated in the activity of
Ethix Corporation in tax year 1991 and [*1134] previous years
in order to satisfy the fifth and sixth tests.

In conclusion, plaintiffs ratable share of the
flow-through operating loss from Cadaja should be characterized as ordinary
loss for tax year 1994.

II. Accuracy-related Penalty

Based on the conclusion that plaintiffs pass-through
loss from Cadaja LLC is an ordinary loss for tax year 1994,
defendants assessed accuracy-related penalty against plaintiffs is
improper.

CONCLUSION

The defendants summary judgement motion (doc. # 32) is
denied and plaintiffs cross-motion for summary judgement (doc. # 40)
is allowed. The parties are directed to confer and agree upon a final order
which specifies all payments and/or refunds in accord with this opinion. The
order should be submitted to the court for signature.